S&P Downgrade

I fully expect the markets to be extremely volatile over the next few weeks as investors try and sort through the ramifications of the Standard and Poor’s downgrade of the U.S. During this time I hope to post frequently and offer a perspective on events as they unfold.

Today we’re seeing a major selloff in equities, currently down about 3% as of late morning on Monday. Let’s take a look at why.

First, what is NOT happening. U.S. interest rates are not skyrocketing up based on the “downgrade”. In fact the opposite is true. Interest rates on U.S. Treasuries are actually lower than they closed on Friday. Why? Everything is relative. While domestically the downgrade is the topic, the global reality is that Europe is still the same mess that it was on Friday. And our downgrade has more of an effect on Europe than it does on the U.S. There is no question that the U.S. is still the big dog in the global world of financial markets. We will not default on any of our payments. Period. The same cannot be said for the troubled countries in Europe – Greece, Spain, Italy, Ireland and Portugal. Although France is not on the “watch” list, they do not have the financial strength of the U.S. As such all the aforementioned countries will necessarily receive a downgrade to reflect their strength, or lack thereof, compared to the U.S.

Back home, you have government backed entities, such as FNMA and FMAC that cannot maintain higher ratings then the entity (the U.S. Government) that is backing them. Such downgrades will then ripple through the bond markets, as virtually everything will need to be moved down a notch in terms of their own ratings. We’re seeing this now as JNK – the SPDR High Yield Corporate Bond ETF, is dropping over 3%. (We sold our holdings of JNK last week when our signals triggered the sell). Overseas, Israeli bonds are suffering as their credit rating is based on the credit backing of the U.S.

Bottom line, is that the U.S. is still the largest and most stable of the world’s major economies. And in times of turmoil there is a financial flight to quality. That flight is into U.S. Treasuries which in turn is driving up prices – which drives down yields.

Tomorrow the Fed meets, expect a strongly worded statement from Mr. Bernanke on the solvency of the U.S., and the steps that the Fed will take to reassure global investors. That should at least temporarily halt the bleeding in the stock markets. Whether an actual rally can ensue will be determined by the ECB, and how they will handle their financial problems with Spain and Italy.

If your portfolio is not already in cash, or hedged my next post will address the decision making process on how and when to change your portfolio’s strategy. Our firm’s strategies are well defined and determined well in advance of our recent selloff. I can’t imagine looking at today’s market, and trying to make a rational decision on whether to sell, or hold on for this to pass.

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bill@401advisor.com • 937.434.1790

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Charles H. Dow Award Winner 2008. The papers honored with this award have represented the richness and depth of technical analysis.

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